The Evolution of Finite Reinsurance and Financial Accounting Statement (FAS)
113
May 2008
Long ago and not so far away, during the late
1980s to be precise, a new form of alternative risk financing hit the scene.
Finite reinsurance, also known as financial reinsurance, expanded the definition
of insurance as we understood it. In so doing, it (briefly) represented an early
example of the so-called convergence of insurance and finance.
by Donald
J. Riggin
Albert Risk
Management Consultants
In the late 1980s, a new reinsurer, Centre Re, was formed by two visionaries:
Steven Gluckstern and Michael Palm. While many of Centre Re's risk financing
techniques already existed at the time, (retroactive liability insurance for
the MGM Grand loss in the early 1980s, loss portfolio transfers, etc.), Centre
Re gathered them all together under a common name—finite reinsurance. Centre
Re's founders made a huge splash and then departed the scene, but the genie
was indeed out of the bottle.
Now, in addition to risk managers and insurance buyers, CFOs and accountants
were attracted to the business of insurance as an alternative method of smoothing
earnings over multiyear policy terms. In these pre-Enron years, companies added
finite reinsurance to their arsenal of financial management tools. Earnings
smoothing, also known as "controlling volatility," was and is highly desirable,
and contrary to popular opinion, it is not illegal per se. Without getting bogged
down in the minutiae, what became questionable was the use of this product to
misrepresent financial results, thus misleading shareholders into thinking that
the company was doing better than it actually was. Did anyone think, back in
the day, that using a quasi-insurance product to smooth earnings would constitute
fraud? Probably not.
Finite Insurance Primer
For those of you who don't know what finite reinsurance is, here's a very
brief primer. The hallmark of any finite risk deal is how its loss reserves
are funded. Instead of paying a relatively small premium in exchange for a huge
limit of liability (real insurance), in finite deals, the premium and the limit
of liability were the same. Here's how it worked. Think of a risk, any risk—environmental
impairment, for example. You determine that if the former landfill on which
you built those 10,000 apartments starts leaking toxic substances, you really
should have some sort of reserve fund from which to buy off potential claimants.
Because you have more money than Bill Gates, you stick $20 million into a finite
reinsurer.
You've been told that this "premium" might just be tax deductible, which
sweetens the deal immensely. The offshore reinsurer sets up your own "experience
account" into which the funds are deposited, provides you with a guaranteed
rate of return on your funds, and tells you that at the end of the 3- or 5-year
policy term, you can get it all back—whatever wasn't paid to the odd disgruntled
tenant, that is. As they say back in the old country … such a deal! But it gets
better.
You didn't even have to deposit the entire $20 million, just its present
value based on a discount rate and the number of years in the policy period.
This assured that, given the guaranteed interest rate and no losses, the fund
would equal $20 million at the end of the policy term. The expenses associated
with such arrangements varied, but in your view, it was well worth it. The upshot
is this: real insurance operates on the principle of the "law of large numbers"—the
premiums of the many pay the losses of the few. Finite reinsurance, however,
relied on the time value of money, and not what we generally call the "insurance
mechanism."
For about 5 years, many of us in the alternative risk financing game became
intoxicated by the sheer possibilities of finite reinsurance. Centre Re's annual
reports during the late 1980s and early 1990s were unlike that of any other
insurer or reinsurer. They were brilliantly written and included ever more exotic
case studies of actual clients, both primary insurers and noninsurance entities,
solving seemingly intractable problems though finite reinsurance.
FAS 113 Arrives on the Scene
Eventually the Financial Accounting Standards Board (FASB) realized that
we needed new guidance, beyond that provided in FAS 5, to determine whether
a transaction could assume insurance accounting. Aimed squarely at finite reinsurance,
FAS 113 was promulgated in 1992. While the statement also includes a cash-flow
test, its most onerous requirements involve its definition of insurance as it
pertains to the likelihood of a loss. It says that there must be a reasonable
chance of a significant loss for insurance accounting to be used (which is the
Holy Grail, by the way). Huh? What does this mean, exactly? Typical of those
august organizations that write the rules, the FAS purposely did not elaborate
on whether a given transaction did or did not qualify.
Meanwhile, back on the farm, few of us paid much attention to FAS 113, and
mistakenly reasoned that it would take years for the FAS to catch up and actually
enforce this thing. Moreover, few of us thought that what we were doing couldn't
be justified as real insurance under the broad FAS 113 guidelines.
Fortunately, the American Institute of Certified Public Accountants (AICPA)
came to our rescue in the form of what became known as the "10/10" rule. Contrary
to popular opinion, FAS 113 does not say anything about the so-called 10/10
rule—it was a construct devised by accountants who determined that if a finite
transaction exhibited a 10 percent chance of a 10 percent loss, it was defensible
in a challenge. Mind you, this means that 10 percent of the risk must then be
actually transferred to another risk-bearing entity. Over time, various accounting
organizations developed their own opinions. One rule of thumb said that for
the transaction to qualify for insurance accounting, the transferred portion
of the risk should be equal to the (primary) loss fund.
The main problem we faced was not quantifying 10 percent of the possible
loss—that was easy; in the above example, this figure was $2 million (10 percent
of $20 million). The sticky wicket was coming up with how to determine the likelihood
of such a loss. Actuaries are used to predicting future losses based on historical
loss data. But, in the vast majority of finite deals (if not all of them), there
was no reliable historical loss data; not even proxy or industry data.
So, instead of looking backward, we started looking forward, and asked this
question: "even though we can't quantify it, isn't it safe to say that, given
the exposure (the key), this bomb could drop at any time, causing considerable
loss?" Why, of course it could! Yes, that's the ticket, and if we come close
to purchasing a reasonable amount of excess risk transfer, we're good to go.
So let's revisit our example. Is there a chance that a former landfill would
eventually begin to bubble up a bit of primordial ooze? You bet there is.
Back to the Future
Fast forward through the 1990s and wham—Enron happens. Enron's meltdown,
while not directly related to the misuse of finite reinsurance, ignited the
New York Attorney General's conflagration that spread through the financial
services industry, extracting enormous fines from the like of Merrill Lynch
among others, and eventually focused on the business of insurance. Along with
other infractions (bid-rigging, etc.), finite reinsurance came under the microscope.
In April 2006, ACE Insurance Company admitted wrongdoing in a 2000 finite reinsurance
transaction involving another insurer. ACE admitted that the finite arrangement
was designed to bolster its financial position, and ultimately contained no
actual risk transfer. It was fined $80 million. Zurich, St. Paul, and Chubb
were also nabbed doing these deals. They were fined $153 million, $77 million,
and $17 million, respectively.
Needless to say, this sort of thing rather shut down the market for finite
reinsurance. Already prior to the attorney general's investigation, conservative
financial consultants were warning against relying on the aforementioned 10/10
rule, recommending something like 30/30 or higher.
Looking Ahead
So, what's the future for FAS 113? Back in May 2006, the FASB issued an Invitation
to Comment on proposed changes. Specifically, it proposed that every insurance
transaction should be examined, and if a noninsurance component is present,
it should be recognized separately and accounted for using deposit accounting
instead of insurance accounting—bifurcation. As of December 2007, the FASB announced
the following.
The Board plans to issue an Exposure Draft [of its revised Statement 113]
in the second quarter of 2008 that will (1) clarify the level of insurance
risk transfer required for a contract to be accounted for as reinsurance,
(2) clarify that noninsurance entity policyholders must evaluate whether
contracts they hold transfer significant insurance risk, and (3) improve
insurance and reinsurance disclosure requirements.
Stay tuned, my friends. When this comes down, you'll be one of the first
to hear about it.
Note: Nothing in this
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